Why Investing in Private Companies Is Ridiculous Even If the SEC Allows it

SEC chairman Jay Clayton is reportedly considering making it easier for everyday investors to invest in their favorite startups. Makes sense on paper as these often leading-edge firms continue to see robust valuations in private markets.

"Venture capital-backed companies are staying private longer and seeing higher valuations," said Alan Wink, director of Capital Markets at EisnerAmper. "The companies are continuing to raise later and later rounds of capital and therefore are showing better customer traction, higher and more sustainable revenues and significant earnings."

This sounds potentially profitable for average investors, right?

Well, it might be. But it also may be the apple to the investor's Eve. While many investors mourn the chance of being able to invest in Uber when it was just starting off (it's now reportedly worth $72 billion), it's important to remember that there are other hot startups that sound great but could shaft investors. Blood-testing startup Theranos is one such startup that comes to mind.

It's now liquidating its assets after the downfall of its TV-loving founder Elizabeth Holmes. Theranos was once valued at $10 billion. It also had a flashy board filled with ex. politicians (former Secretary of State Henry Kissinger) and big-name former CEOs (former Wells Fargo (WFC - Get Report) CEO Dick Kovacevich).

Everything seemed to be above aboard. No go.

The Reality

"The devil is 100% in the details," said JJ Kinahan, Chief Market Strategist at TD Ameritrade. Although he believes that the opportunity to score big with an up-and-coming company could be "exciting," it doesn't mean that investors should ignore the risks associated with investing in a private company.

"For every Uber or Lyft that Softbank is making an IPO replacement investment into...there's a lot of companies that never make it that far," cautions Charles Clinton, CEO of EquityMultiple.

One such risk, which should be obvious, is the fact that private companies are not required to report their financials and other information in the same way. That could prove to be a potential issue for investors new to putting money into private companies.

When venture capital groups--such as SoftBank or Andreeson Horowitz--invest in private companies, there are teams of people looking into the companies to determine the risks and figuring out why, or why not, a company is a worthwhile investment.

"Venture capitals perform significant due diligence before they invest, will the individual investor," asked Wink. He also noted that venture capital groups have large amounts of capital to invest, in effect play money. The kind of capital that the majority of investors don't have access to or could ill afford to lose.

A Solution

But perhaps there is a compromise here. Instead of opening up private companies to every investor, open them up to investors who have met some form of qualifications.

"I think opening up avenues for people who can prove one way or another that they understand this stuff [is important]," said Clinton. "Certain types of investing is different than other investing."

Clinton even puts forward a suggestion, "simply expanding the the definition of accredited" may be beneficial.

If the system is perfected, it wouldn't be very different from "professional angel investing," said Wink.

"There are risks, of course, like with any type of investing, but it's not rocket science," says Stan Bokov, COO of TradingView. "Due diligence, research and trusting the founding team are key aspects of success."

But the question remains: how many everyday investors will actually do their due diligence? Just because investors like a product doesn't mean that they should invest in the company.

After all, one thing that Jim Cramer, founder of TheStreet, preaches continuously is, "Before you buy any stock, please, please, do your homework."

And he says that about shares of public companies, so obviously the need for due diligence increases ten-fold for private companies.

So, unless you really know what you're doing, don't be dumb and go all in on private companies if the SEC opens the books.

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Should Disney execute well on its transition plan over the next few years, an investment in the stock at current levels will likely be properly justified, proving the forward earnings multiple of 20x to be overly conservative.